SOFR for corporates: Considerations on debt and derivatives in 2022

As the turn into 2022 has ushered the financial markets closer to the LIBOR sunset date^[1], lenders and borrowers alike are faced with the prospect of any new LIBOR-based originations being prohibited. Moreover, the emergence of various versions of SOFR has introduced considerable ambiguity to the path forward, spanning debt, derivatives, and hedge accounting treatment. Meanwhile, as legacy debt and derivatives based on LIBOR can persist until June 2023, borrowers are left grappling with the tension of taking action now versus waiting. This article lays out the important considerations and alternatives for corporations facing a SOFR trigger event in the debt or derivatives markets during this seminal market transition period.

Debt originations

When it comes to new debt, without LIBOR as a viable alternative, borrowers will have to contend with the question of which version of SOFR best fits their institutional needs. While some lenders may require one version over the other, borrowers should be aware of the various nuances so they can advocate for their own best interest in loans. The following list comprises the most common rates observed in the incipient post-LIBOR market:

• Daily Simple SOFR: Also known as ‘Daily Average SOFR’, this rate represents a daily weighted average (weights applied for weekends and holidays) of daily SOFR over an interest accrual period, without compounding. Various conventions can be applied in terms of lookback days or payment delays to facilitate a gap between a payment amount being known versus due.
• SOFR Compounded in Arrears: Also known colloquially as ‘SOFR-compound’, this rate follows the Daily Simple SOFR convention but includes the element of compounding each day of interest during the accrual period. It will also apply lookback or payment delay conventions as described above. It is worth noting this is the rate used in ISDA’s LIBOR fallback mechanism for derivatives.
• NY Fed Average SOFR: For a given accrual period, this rate takes a compounded average of the prior accrual period, such that the rate is known at the beginning of an interest period. For example, interest during an accrual period across the month of April, due at the end of April, is known at the beginning of April based on compounded average SOFR rates during March. This rate has the obvious advantage of being known at the beginning of a period but the disadvantage of being potentially unrepresentative of the actual rate environment during an accrual period.
• CME Term SOFR: The only pure forward-looking SOFR rate, CME Term SOFR uses SOFR futures and benchmark SOFR derivatives to provide a forward rate for a given time period. Absent the inclusion of any credit-sensitive element, CME Term SOFR mimics LIBOR in that it sets at the beginning of an interest period based on forward-looking market data. Notably, CME Term SOFR is at the top of the ARRC’s^[2] LIBOR fallback waterfall for loans. It is expected to have broad uptake for corporate borrowers, though as of this writing its derivatives market is still developing.
• BSBY: The Bloomberg Short-term Bank Yield Index has been less common than SOFR iterations, though it has made a notable footprint. This rate has the advantages of mimicking LIBOR’s advance setting and term-structure nature, while historically tracking tightly with the legacy index. Its disadvantages include its lack of full endorsement from regulators, its more limited uptake as compared to SOFR, and a less liquid derivatives market for this index.

In addition to the SOFR rates listed above, most loans would include a Credit Spread Adjustment (CSA) as well. This adjustment is a fixed number to replicate the credit-sensitive nature of LIBOR which is not represented in SOFR. It is unclear whether such spreads will only be present during this transition phase away from LIBOR, versus persisting beyond the discontinuation of LIBOR entirely.

In terms of trigger events, regulators have clarified that minor amendments of existing debt or drawdowns on existing LIBOR facilities would not trigger an amendment to SOFR. However, an extension or upsize of a LIBOR-based facility would constitute a shift to SOFR as the reference rate. As of this writing, most companies with legacy LIBOR debt have not made a proactive shift away from LIBOR—absent a trigger event—and are rather waiting for such a trigger event to occur or are waiting for more market precedent to amend a LIBOR-based loan. In many cases, such a shift would trigger changes in company derivative positions, which we detail in the following section.

Derivative applications

Similar to the market practice on loans, most companies have yet to proactively amend their derivatives away from LIBOR without the prompting of a trigger event on the debt side. However, as market liquidity continues to develop and more companies begin borrowing on SOFR, we expect more companies to begin proactively converting LIBOR derivatives to SOFR. In the meantime, legacy LIBOR derivatives continue to be a sound hedge for LIBOR-based debt.

When it comes to hedging SOFR-based debt, in most cases best practice would be to match the exact version of SOFR being used in the debt itself, as this will provide the best economic and hedge accounting results. For companies hedging legacy LIBOR debt, they are still able to do so on LIBOR-based derivatives. However certain derivatives which are not directly hedging LIBOR-based debt can no longer reference LIBOR; indeed, these markets have moved to primarily SOFR:

• Hedging SOFR-based debt: Derivatives markets are liquid for the iterations of SOFR listed above. As described above, borrowers should seek to match the structure of their derivative with that of their debt. However, it is worth noting that as of this writing some banks are more ‘online’ with certain versions of SOFR than others. In the case of CME term SOFR, liquidity is smaller than that of SOFR-Compound because banks are trading SOFR-Compound with each other. However, liquidity charges for Term SOFR thus far do not appear to be significant.
• Pre-issuance hedging with swaps: If hedging a future fixed-rate issuance with swaps (as opposed to Treasury locks), the borrower will enter into a swap where they pay a fixed rate and receive compounded SOFR, the trade being cash-settled upon issuance of the fixed-rate debt. This market has primarily gravitated to SOFR-compounded in arrears as the reference rate, though there is variability in terms of payment frequency, lookbacks, and payment delays.
• Receive-fixed swaps: For companies swapping fixed-rate debt into floating, this market has also moved fully away from LIBOR and primarily to SOFR-based trades. There is some variability in the exact floating structure being used, as some companies prefer the liquidity of SOFR-compounded while others prefer the forward-setting nature of Term SOFR. This landscape will likely continue to evolve as derivative liquidity deepens and market participants increase.
• Deal contingent swaps for future financing: For companies hedging a future floating rate financing with a deal contingent swap, the best hedge would reference the same rate being used in the debt. Thus, these trades would no longer be on LIBOR, but in some cases, the future rate is not fully known as these trades are executed in the midst of the financing being negotiated. Thus far, SOFR-compounded seems to be the most common reference rate for this market.

Hedge accounting implications

From the accounting perspective, reference rate reform has presented technical and operational challenges to organizations to continue the existing contract accounting and hedging relationships uninterrupted. FASB issued ASU 2020-04 Reference Rate Reform (Topic 848) on March 12, 2020, to provide some relief to the transition efforts related to reference rate reform. However, due to the ever-changing market environment during this transition period, practical interpretations of ASC 848 continue to evolve. We have highlighted below some common accounting challenges related to the application of ASC 848:

Are the contract modifications in-scope of ASC 848?

ASC 848 is only intended to provide accounting relief for contract modifications related to reference rate reform. Therefore, only qualifying modifications to the derivatives or the debt agreements are covered by ASC 848 and would not trigger de-designation of existing hedging relationships. However, in practice, many corporations are transitioning from LIBOR to SOFR debt as part of a refinancing transaction, which often included an extension and upsizing of the existing debt. While the change to the index is a qualifying modification, the changes to principal, maturity date, and other critical terms are considered unrelated to reference rate reform and could trigger the Company to perform the modification vs. extinguishment assessment as described in ASC 470. Additionally, an addition of an in-the-money (at spot) floor to the existing debt could also be considered an out-of-scope modification and thus challenging the continuance of existing hedging relationships. We recommend closely assessing all contractual changes to the critical terms of the derivatives and debt agreements to determine whether the contract modifications are in-scope or out-of-scope of ASC 848 and whether existing hedging relationships can continue without de-designation.

Can we qualify for hedge accounting if we have new SOFR-based receive-fixed derivatives hedging fixed-rate instruments?

Since the beginning of 2022, Companies hedging the pre-issuance of fixed-rate issuances or entering new fair value hedges of fixed-rate debt can no longer reference LIBOR. As such, we are seeing an uptick of SOFR-based swaps related to pre-issuance hedging and fair value hedging strategies. A key consideration here is whether the hedged interest rate risk qualifies as a benchmark interest rate. SOFR Overnight Index Swap Rate is an eligible benchmark interest rate in accordance with ASC 815. However, CME Term SOFR is not considered a benchmark interest rate. Therefore, it could be significantly more challenging for CME Term SOFR based derivatives to qualify for hedge accounting under the pre-issuance hedging and fair value designation strategies currently. However, the FASB has decided to expand the benchmark rate definition to any swap rate based on SOFR. Once the new ASU is issued, CME Term SOFR will qualify as an eligible benchmark interest rate for these hedging strategies.

Can we take the wait-and-see approach, and what would be the accounting implications?

The sunset date for ASC 848 is December 31, 2022. However, given legacy LIBOR-based contracts can persist until June 30, 2023, the FASB has decided to defer the sunset date to December 31, 2024. Due to the significant operational work involved in amending the derivatives, updating the hedged item/hypothetical derivatives, creating new regressions and valuations, and updating hedge documentation, we recommend setting aside sufficient buffer time before the transition deadline to address potential accounting and operational challenges that could arise during the transition.

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[1] LIBOR is scheduled to be discontinued after June 30, 2023

[2] The Alternative Rates Reference Committee has provided best-practice fallback language for LIBOR to be applied in loans